Traditional long-only fixed income managers had one of the worst quarters on record in Q1 2022, as higher interest rates left ‘bottom up’ portfolios overweight duration.
In a world where macro variables drive returns, owning thousands of individual bonds leaves the impossible task for controlling credit and duration risk at the portfolio level. Instead, portfolios constructed with illiquid individual bonds become ‘index-like’ and static, unable to react to new information and new regimes.
Although we do not think the pain is over for these types of portfolios, we do believe fixed income – even in a world where inflation and interest rates are rising – can still be prudently used to help diversify and protect a portfolio from equity drawdowns.
To thrive, managers will need to use liquid alternatives that allow for creative solutions and macro positioning in a low-cost way. The basic 60/40 portfolio might not be as dead as many believe – it just looks different.
Flexible in fixed income
Specifically, to be an effective fixed income investor going forward may require using tools that separate credit from interest rate risk and allow investors to be nimble enough to manage cyclical trends within a secularly shifting world. To this end, allocators must bear in mind two considerations: what is the best way to use Treasuries to manage duration, and why have any duration at all?
These questions are more complex than they first appear. First, cycles almost always overwhelm a secular view. Case in point, during the 40-year bull market in Treasuries, there were nine periods lasting a year or longer (11 years of the 40) where government debt lost more than 5% per year. In other words, throughout the entire four decades, a static portfolio left money on the table versus an actively managed one. Tactical duration management will be key to navigating a secular rising rate environment marked by intermittent periods where yields fall.
Duration comes in many shapes and sizes, especially when constructing a portfolio with ETFs that allow for rate hedged products, and fixed income investors will need to be creative. There has been a meaningful increase in the breadth of fixed income ETFs over the past few years, which now allows investors to be very specific about the type of interest rate and credit exposure they target. Further, ETFs allow managers to be nimble and deviate from their benchmarks without the need to turn over huge portions of their portfolios to change those exposures.
Imagine the following four portfolios built on the day the 10-year yield bottomed on 4 August 2020. Portfolio one has no Treasury exposure; instead, all the portfolio’s rate risk is embedded in short duration investment grade (IG) corporate debt.
Portfolios two, three, and four all have the same underlying holdings – long maturity corporate bonds hedged to zero duration through an interest rate swap – paired with a Treasury position of varying tenors to get to the same duration as portfolio one. The interest rate sensitivity of a portfolio with a 15% weight in 20-plus-year Treasuries and 85% interest rate-hedge IG corporate bond exposure is more or less equivalent to that of a portfolio 100% comprised of traditional 1-3-year maturity IG corporate bonds.
Many investors would look at portfolio one as the optimal portfolio because Treasury yields have increased 200bp over the last 20 months. In fact, the best performing portfolio, by a wide margin, is portfolio four, which holds the longest maturity (20-plus-year) Treasury. Though it may not look pretty from an individual holding perspective, investors need to focus on portfolio-level results.
One could question the need for any Treasury exposure, but there is such uncertainty regarding the economic environment, it seems prudent investors have some duration in their portfolio as a recession hedge.
As with all hedges, the ‘premium’ yield given up is the cost for holding the position – i.e., no hedge is free. Given fixed income is often used to dampen equity volatility and protect to the downside in the event of a recession, maintaining a small amount of duration seems to make sense and likely should be added to – while remaining underweight – if rates continue to increase and uncertainty continues to mount.
If an investor who buys a 10-year Treasury at 3% yield held that bond for two years, the level at which yields would need to rise before losing money is about 3.7%. If the 10-year yield increased to 4.5%, a level not seen in 15 years, the cost to hold the position is 3.5% per year. That cost seems reasonable given the investor would make 24% if the economy went into recession at the end of those two years and the 10-year yield fell to 1%.
Maintaining recession protection by holding moderate duration exposure is very different from using Treasuries as a total return investment and overweighting duration. We would likely only take such a position when the probability of recession has gone up significantly from current levels, or if there were other fundamental reasons to shift course, such as rapidly falling inflation or central bank quantitative easing, for example.
We believe being able to manage extreme variations of duration, including knowing when and when not to pair with credit risk, will be vital to portfolio management in what will likely be a secularly rising rate environment marked by periods of rate rallies. To us, that means portfolios constructed using ETFs and focused on macro factors are the future of fixed income management.